Inflation Accounting

A novel way of weighing the impact of rising or falling product prices in various parts of the world.

Inflation accounting is a novel way of weighing the impact of rising or falling product prices in various parts of the world on the declared stats of anything from mom-and-pop shops to multinational corporations.

Inflation Accounting

It has become popular due to the extraordinary inflationary pressure in most nations in recent decades.

Historical expenses become irrelevant during periods of continuous price rises. As a result, they may become deceptive as measures of economic value.

Rather than relying exclusively on cost accounting, financial statements are modified by price indexes to provide a clearer picture of a firm's financial status in inflationary environments. This approach is also known as price level accounting.

This specialized accounting approach is only utilized during inflationary periods when the overall level of prices has been consistently high for three consecutive quarters.

It entails documenting the business's revenue and expenditure at current prices, adjusting all three company accounts, and then analyzing the firm's trend.

This accounting method aims to inject reality into financial statements by altering them to accurately and fairly reflect a company's financial performance and position over a certain period.

Coins

The balance sheet, created for a certain period, comprises items such as cash and debt, which are expressed at actual buying power. Other goods, such as inventories, represent true buying power in monetary terms.

Other balance-sheet assets, such as furnishings, land, plant, and equipment, are stated at historical cost, with possible appreciations or depreciations attached.

As a result, financial statements made without accounting for changes in the buying power of the monetary unit lose importance. As a result, there is a push for businesses to provide inflation-adjusted financial statements. 

The subject "inflation accounting" studies the various methods for adjusting financial accounts to changing prices.

How does it work?

When a corporation works in a nation with high price inflation or deflation, past information on financial accounts becomes obsolete.

Cash and coins

To address this issue, corporations are authorized, in some situations, to utilize inflation-adjusted statistics, restating data to reflect actual economic realities.

International Financial Reporting Standards (IFRS) IAS 29 governs organizations whose functional currency is the currency of a hyperinflationary economy.

The IFRS defines hyperinflation as rates, debt, and salaries related to a price index that grows by 100 percent or more over three years.

Businesses in this category may need to modify their accounts frequently to keep them relevant to current economic and financial situations, augmenting cost-based financial statements with price-level adjusted statements.

These businesses must keep track of the changing value of their costs, profits, assets, etc. over time. This helps companies account for changes in their spending and ensure that they appropriately estimate future budgets.

Furthermore, suppose your organization manufactures goods and services vulnerable to inflation, which most are. In this case, you must utilize price level accounting to keep track of the changing prices of your costs over time.

Similarly, financial accounting should be used if your organization has fixed assets that depreciate at a specified rate.

Objectives

Price level accounting standards aim to offer consistent, understandable accounting methods in periods of inflation.

Cash in white background

It reflects a company's actual financial situation by reporting all books of accounts at current prices. It updates all records to reflect the current price index to determine true profitability.

This accounting field examines company financial statements to ensure that earnings are not over or understated. All costs and income are stated in current dollars to achieve this.

It calculates the proper amount of depreciation based on the present worth rather than the previous value. Accounting for allowable depreciation allows businesses to value investments easily.

It helps enterprises compare their inter-period performance to determine their profitability quickly. To minimize misinterpretation of historical data, inflation accounting adjusts the impact of price fluctuations on all costs and earnings stated in financial statements.

It gives accurate information to shareholders and employees depending on the latest price level. In the lack of such knowledge, these individuals may demand a greater return and higher compensation.

Its goal is to combine several monetary units with diverse buying powers into a single economic unit with uniform purchasing power for various evaluations and calculations.

It can generate fictitious or fictional profit that does not exist. Hence, the capital maintenance notion is only a theoretical construct, as much of the wealth generated by it is unrealized or holding gain.

Accounting for inflation can compromise the core goal of describing what happens inside a period or at a particular moment.

Features of Inflation accounting 

It reflects a company's fundamental financial status by making market price adjustments in its financial statements. It gives a fair picture of the company's financial situation by reporting all changes caused by the current pricing index.

Full cash

It allows for a more accurate inter-period comparison of earnings by bringing all costs and income up to date. All financial documents, such as the balance sheet and profit and loss account, represent present values rather than past ones, making comparison possible.

It provides an inherent and automated method for modifying the company's book of accounts when the price level increases. It compares income and costs at current prices to depict a company's position accurately.

It keeps a close check on the deceptive actions of historical cost ideas portraying more significant profits and higher taxes, resulting in higher salaries being sought by employees perceiving the increased earnings.  

These requests will not exist if all price level reporting changes are done. This discipline of accounting aids in the removal of all inaccuracies caused by previous data.  

It ensures the accuracy of financial accounts by amending all statistics and aligning current revenues with current costs.

It is a robust management tool that aids in efficient decision-making. Price level accounting gives reliable data that is updated to current prices. After revisions, the balance sheet shows a fair situation, which assists managers in making sound judgments.

Methods

There are two main methods to perform inflation accounting:

1. Current Purchasing Power (CPP):

Current purchasing power requires businesses to record and report their financial accounts using historical statistics. A universal price index converts various statistics from a company's financial statements.

The purchasing power of money is prioritized in this strategy, whereas changes in item prices are ignored. The CPP technique entails restating historical figures at current buying power. Historical statistics must be multiplied by conversion factors for this purpose.

It divides all assets and obligations into two categories: monetary items and non-monetary items. 

Monetary items are assets and liabilities whose values are only receivable or payable at their present financial worth, for example, cash, accounts payable, and accounts receivable.

Non-monetary objects cannot be stated in a set monetary value. These are assets and liabilities that do not have particular financial claims-for example, land, construction, and other non-monetary accounts.

2. Current Cost Accounting (CCA):

Under the current cost accounting approach, assets are reported in financial statements, such as the balance sheet and income statement, at their current price rather than their historical cost or original value.

Profit is calculated using the asset cost at the time of sale rather than the actual cost. Depreciation is added to current values, preventing profit overvaluation and preserving capital. 

A comprehensive inflation accounting system provides a more accurate perspective of the company by effectively accounting for all price increases.

The business' profit under CCA can reveal how the company has benefited financially from the increase in the price level, something neglected by historical cost accounting.

Proponents of CCA claim that distinguishing operating profit from holding profits and losses improves the relevance of the information it provides.

Advantages

Inflation accounting is a novel way of weighing the effects of rising or falling product prices in various parts of the world on the declared data from a wide range of firms.

  • Firms may provide a more accurate picture of their financial status using price level accounting. It is the process of making changes to reconcile current revenues with current costs.

  • It makes firm profit comparisons fairer by updating all financial accounts to the current value. The profitability of two different plants acquired at separate times may be quickly compared since it is determined at present value rather than historical cost.

  • It lets a corporation offer a realistic image of its balance sheet by adjusting it for inflationary effects. As in historical accounting, all assets are displayed at their current valuations rather than distorted values.

increasing graph

  • It helps the company preserve its actual capital by keeping an eye on dividend payments to its shareholders. It guarantees that dividends and taxes are paid based on current adjusted profits rather than profits exaggerated in previous accounting.

  • It aids in computing the correct amount of depreciation by using the asset's current value as the basis for charging depreciation rather than its one-time cost. Furthermore, precise depreciation computation allows organizations to replace assets easily.

  • It eliminates the possibility of financial statements over or understating firm income. Under this accounting method, all financial statements are modified to reflect the present economy based on the current price index.

Disadvantage

Inflation accounting is a unique approach used to account for the influence that rising or falling commodity prices has on the reported numbers of firms.

  • The major disadvantage of price level accounting is that price changes are a never-ending process that occurs indefinitely. Changing financial statements for every period as inflation or deflation occurs becomes a time-consuming operation.

  • It may result in an overstatement of strong earnings during deflationary periods, which is damaging. 

  • Prices decrease abruptly during periods of deflation; modifications to the price level at this time will result in the corporation charging less depreciation, leading profits to be exaggerated.

Decreasing

  • It is just a theoretical practice since it involves the window dressing of accounting ideas to fit the needs of consumers.

  • This accounting method is quite costly. As a result, small firms cannot afford to include it in their operations.

  • It is a difficult skill to master since it necessitates several modifications to financial statements. 

  • Multiple computations and possibly undesired changes must be done, making it a challenging chore for the average person. In addition, price changes are ongoing, making it challenging to restate the company's data and show the financial statements each time.

  • Extensive computations and modifications are required. These cannot be performed by unskilled accountants and bookkeepers.

Example

The first example of price level accounting is as follows. Company ABC is in the manufacturing business and purchased machinery in 2003 for $15,000. 

The company used the price level accounting method to restore records in 2010. Find the current cost of the machine purchased in the year 2001.

The general price index in 2003 was 500 and 800 in 2010. This means that,

Historical cost = $15,000

Basic price index = 400

Current price index = 800

Current cost = (Current price index/Basic price index)*historical cost = (800/400)*15,000 = $30,000

So, the current value is $30,000, which would be recorded as the closing balance on the balance sheet.

The second example is as follows. Company XYZ operated in construction and acquired a plot of land in 2002 for $10,000. XYZ is employing inflation accounting to restore its financial information to 2003. 

Coin stack

Determine the current cost of a property lot acquired in 2002 if the general price index in 2002 was 400 and 500 in 2003.

This means that,

Historical cost = $10,000

Basic price index = 400

Current price index = 500

Current cost = (Current price index/Basic price index)*historical cost =(500/400)*10,000 = $12,500

So, the current cost is $12,500, which would be recorded as the closing balance on the balance sheet.

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Researched and authored by Ajay Kumar Sahoo | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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